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Interest Rate Swaps
Interest rate swaps are financial agreements between two parties to exchange interest rate payments. They are used to manage or hedge against interest rate risk. In a typical interest rate swap, one party pays a fixed interest rate while the other pays a floating interest rate, allowing both parties to benefit from their respective advantages in the market.
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12 Key excerpts on "Interest Rate Swaps"
eBook - PDFCapital Market Instruments
Analysis and Valuation
- M. Choudhry, D. Joannas, G. Landuyt, R. Pereira, R. Pienaar(Authors)
- 2009(Publication Date)
- Palgrave Macmillan(Publisher)
Interest Rate Swaps Introduction Interest-rate swaps are the most important type of swap in terms of volume of trans- actions. They are used to manage and hedge interest rate risk and exposure, while market makers will also take positions in swaps that reflect their view on the direction of interest rates. An interest rate swap is an agreement between two 313 16 Swaps counterparties to make periodic interest payments to one another during the life of the swap, on a pre-determined set of dates, based on a notional principal amount. One party is the fixed-rate payer, and this rate is agreed at the time of trade of the swap; the other party is the floating-rate payer, the floating rate being determined during the life of the swap by reference to a specific market index. The principal or notional amount is never physically exchanged, hence the term ‘off-balance sheet’, but is used merely to calculate the interest payments. The fixed-rate payer receives floating-rate interest and is said to be ‘long’ or to have ‘bought’ the swap. The long side has conceptually purchased a floating-rate note (because it receives floating-rate interest) and issued a fixed coupon bond (because it pays out fixed interest at intervals), that is, it has in principle borrowed funds. The floating-rate payer is said to be ‘short’ or to have ‘sold’ the swap. The short side has conceptually purchased a coupon bond (because it receives fixed-rate interest) and issued a floating-rate note (because it pays floating-rate interest). So an interest rate swap is: • an agreement between two parties • to exchange a stream of cash flows • calculated as a percentage of a notional sum • and calculated on different interest bases. For example in a trade between Bank A and Bank B, Bank A may agree to pay fixed semi-annual coupons of 10% on a notional principal sum of £1 million, in return for receiving from Bank B the prevailing six-month sterling Libor rate on the same amount.
eBook - PDFCapital Market Instruments
Analysis and valuation
- M. Choudhry, D. Joannas, R. Pereira, R. Pienaar(Authors)
- 2004(Publication Date)
- Palgrave Macmillan(Publisher)
There is also a close relationship between the bond market and the swap market, and corporate finance teams and underwriting banks keep a close eye on the government yield curve and the swap yield curve, looking out for interest-rate advantages and other possibilities regarding new issue of debt. We do not propose to cover the historical evolution of the swaps markets, which is abundantly covered in existing literature, or the myriad of swap products which can be traded today (ditto). Instead we review the use of interest-rate swaps from the point of view of the bond market participant; this includes pricing and valua- tion and its use as a hedging tool. There is also an introduction to currency swaps and swaptions. The bibliography lists further reading on important topics such as pricing, valuation and credit risk. Interest Rate Swaps Introduction Interest-rate swaps are the most important type of swap in terms of volume of transactions. They are used to manage and hedge interest rate risk and exposure, while market makers will also take positions in swaps that reflect their view on the 329 CHAPTER 15 Swaps M. Choudhry et al., Capital Market Instruments © Moorad Choudhry, Didier Joannas, Richard Pereira and Rod Pienaar 2005 direction of interest rates. An interest rate swap is an agreement between two coun- terparties to make periodic interest payments to one another during the life of the swap, on a pre-determined set of dates, based on a notional principal amount. One party is the fixed-rate payer, and this rate is agreed at the time of trade of the swap; the other party is the floating-rate payer, the floating rate being determined during the life of the swap by reference to a specific market index. The principal or notional amount is never physically exchanged, hence the term ‘off-balance sheet’, but is used merely to calculate the interest payments. The fixed-rate payer receives floating-rate interest and is said to be ‘long’ or to have ‘bought’ the swap.
eBook - PDFCredit Risk Modeling
Theory and Applications
- David Lando(Author)
- 2009(Publication Date)
- Princeton University Press(Publisher)
7 Credit Risk and Interest-Rate Swaps An interest-rate swap is a contract by which the parties agree to exchange a constant, fixed payment stream for a variable payment stream. The variable payment stream, the so-called floating leg of the contract, is typically linked to three-or six-month LIBOR rates, an interbank deposit rate which will be defined below. The fixed leg is typically set so that the contract has zero initial value and the size of this fixed leg is referred to as the swap rate. The actual dollar size of the payments is computed from a notional value of the contract, but in interest-rate swaps this notional value is only for calculation purposes: it is never exchanged. The market for interest-rate swaps has reached an enormous size. Current esti-mates in Bank of International Settlements (2003) are that the size of the euro swap market by the end of 2002 had an outstanding notional amount of $31.5 trillion, and that the corresponding amount for the dollar market was $23.7 trillion. This is of course an enormous amount but it tends to exaggerate the size of the cash flows involved since it is common practice in the swap markets to close out positions by taking new offsetting positions in swaps instead of getting out of the existing swaps. Still, the volume is large, and it is partly a reflection of the fact that swap markets are increasingly supplementing government bonds for hedging and price discovery in fixed-income markets. This leads to the natural question of whether swap curves are replacing yield curves on government bonds as “benchmark” curves. A bench-mark curve is a curve against which prices of other securities are measured, but it is also a natural question to think of whether the swap curve is a better measure of the riskless rate. Whether we use swap curves as benchmarks or even consider using them as proxies for a riskless rate, we need to understand their meaning and their dynamics.
eBook - PDF- Jeff Madura(Author)
- 2020(Publication Date)
- Cengage Learning EMEA(Publisher)
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 379 15 Swap Markets CHAPTER OBJECTIVES The specific objectives of this chapter are to: ■ ■ Provide background information on Interest Rate Swaps. ■ ■ Describe the types of swaps that are available. ■ ■ Explain the risks of Interest Rate Swaps. ■ ■ Explain how Interest Rate Swaps are priced. ■ ■ Identify factors influencing interest rate swap performance. ■ ■ Identify other inter- est rate derivative instruments that are commonly used. ■ ■ Explain how credit default swaps are used to reduce credit risk. ■ ■ Describe how the swap markets have become globalized. Many firms have inflow and outflow payments that are not equally sensitive to interest rate patterns. Consequently, they are exposed to interest rate risk. Interest rate swap contracts have been established to reduce these risks. In addition, credit default swap contracts have been established to reduce credit risk. 15-1 Background An interest rate swap is an arrangement whereby one party exchanges one set of interest payments for another. In the most common arrangement, fixed-rate interest payments are exchanged for floating-rate interest payments over time.
eBook - PDF- (Author)
- 2021(Publication Date)
- Wiley(Publisher)
The reading concludes with a summary. 1.1. Changing Risk Exposures with Swaps, Futures, and Forwards Financial managers can use swaps, forwards, and futures markets to quickly and efficiently alter the underlying risk exposure of their asset portfolios or anticipated investment transactions. This section covers a variety of common examples that use swaps, futures, and forwards. 1.1.1. Managing Interest Rate Risk 1.1.1.1. Interest Rate Swaps An interest rate swap is an over-the-counter (OTC) contract between two parties that agree to exchange cash flows on specified payment dates—one based on a variable (floating) interest rate and the other based on a fixed rate (the “swap rate”)— determined at the time the swap is initiated. The swap tenor is when the swap is agreed to expire. Both interest rates are applied to the swap’s notional value to determine the size of each payment. Normally, the resulting two payments (one fixed, one floating) are in the same currency but will not be equal, so they are typically netted, with the party owing the greater amount paying the difference to the other party. In this manner, a party that currently has a fixed (floating) risk or other obligation can effectively convert it into a floating (fixed) one. Interest Rate Swaps are among the most widely used instruments to manage interest rate risk. In particular, they are designed to manage the risk on cash flows arising from inves-tors’ assets and liabilities. Interest Rate Swaps and futures can also be used to modify the risk and return profile of a portfolio. This is associated with managing a portfolio of bonds that Chapter 9 Swaps, Forwards, and Futures Strategies 495 generally involves controlling the portfolio’s duration. Although futures are commonly used to make duration changes, swaps can also be used, and we shall see how in this reading.
eBook - ePubAn Introduction to International Capital Markets
Products, Strategies, Participants
- Andrew M. Chisholm(Author)
- 2009(Publication Date)
- Wiley(Publisher)
13 Interest Rate Swaps13.1 CHAPTER OVERVIEW
This chapter explores one of the fundamental tools of the modern capital markets, the interest rate swap (IRS). A standard or ‘plain’ vanilla IRS is an agreement between two parties to exchange cash flows on regular payment dates. One leg is based on a fixed rate of interest and the return leg on a variable or floating rate of interest. The chapter considers how payments on the swap are calculated. It looks at the trading and hedging applications for corporate borrowers and institutional investors. Nowadays the market for swaps is extremely competitive and dealers working for major banks stand ready to quote two-way prices in a wide variety of currencies for a range of maturities (up to 30 years and beyond) and for a range of payment frequencies. The chapter discusses swap spreads which measure the relationship between the fixed rates on swaps and the returns on benchmark government securities. Spreads are affected by credit risk considerations, by liquidity, and also by supply and demand factors. Many issuers of fixed coupon bonds use swaps to switch their liabilities to a floating rate basis. The chapter considers why this is so and where the benefits lie. The final topic is cross-currency swaps, in which payments are made in two different currencies. The Appendix lists non-standard swap varieties.13.2 SWAP DEFINITIONS
In the most general terms a swap is a contract between two parties:• agreeing to exchange cash flows; • on regular dates; • where the two payment legs are calculated on a different basis.A swap is a bilateral over-the-counter agreement directly negotiated between two parties, at least one of which is normally a bank or other financial institution. Once made, the contract cannot be freely traded. On the other hand, it can be tailored to meet the needs of a particular counterparty. As with other OTC derivatives there is a potential credit risk - the risk that the other party might default on its obligations. To counter this, collateral is normally exchanged.
eBook - PDFFundamentals of Financial Instruments
An Introduction to Stocks, Bonds, Foreign Exchange, and Derivatives
- Sunil K. Parameswaran(Author)
- 2022(Publication Date)
- Wiley(Publisher)
CHAPTER 10 Swaps INTRODUCTION What exactly is a swap transaction? As the name suggests, it entails the exchanging or swapping of cash flows between two counterparties. There are two broad categories of swaps: Interest Rate Swaps and currency swaps. In the case of an interest rate swap, all payments are denominated in the same currency. Obviously, the two cash flows being exchanged will be calculated using dif-ferent interest rates. For instance, one party may compute its payable using a fixed rate of interest, while the other may calculate what it owes based on a market bench-mark such as LIBOR. Such Interest Rate Swaps are referred to as fixed-floating swaps. A second possibility is that both payments may be based on variable or floating rates. For instance, the first party may compute its payable based on LIBOR while the coun-terparty may calculate what it owes based on the rate for a Treasury security. Such a swap is referred to as a floating-floating swap. It should be obvious to the reader that we cannot have a fixed-fixed swap in practice. For example, consider a deal where Bank ABC agrees to make a payment to the counterparty every six months on a given principal, at the rate of 5.25% per annum in return for a counterpayment based on the same principal that is computed at a rate of 6% per annum. Clearly, this is an arbi-trage opportunity for Bank ABC, because what it owes every period will always be less than what is owed to it. No rational counterparty will therefore agree to such a contract. Thus, in the case of an interest rate swap, prior to the exchange of interest on a scheduled payment date, there must be a positive probability of a net payment being received for both the parties to the deal. In the case of an interest rate swap, a principal amount needs to be specified to facilitate the computation of interest. There is no need, however, to physically exchange this principal at the outset.
eBook - PDFForeign Exchange in Practice
The New Environment
- S. Anthony(Author)
- 2002(Publication Date)
- Palgrave Macmillan(Publisher)
CHAPTER 8 Swaps In this chapter, the concepts of currency and Interest Rate Swaps are intro- duced. Currency swaps provide a powerful tool for manipulating cross currency cash flows without creating a net exchange position. They can be used to roll foreign exchange positions and to simulate foreign currency loans or investments. They can also be used to exploit arbitrage opportuni- ties and to manage banking system liquidity. Interest Rate Swaps provide a means of switching interest rate exposures between fixed and floating. Cross currency swaps can be used when floating interest rates are involved. Definition A currency swap is the simultaneous purchase and sale of equivalent amounts of one currency against another currency for different maturi- ties. A currency swap does not create a net exchange position but it does create mismatched cash flows for a period of time. A currency swap is equivalent to two money market transactions. To illustrate this point, consider the cash flows involved when someone buys Australian dollars spot against US dollars and sells Australian dollars three months forward against US dollars (Exhibit 8.1). EXHIBIT 8.1 Cash flow representation of a currency swap 130 A$ Spot US$ + – A$ 3 months US$ – + The cash flows are the same as when borrowing Australian dollars for three months and lending US dollars for three months. The pricing of the swap must therefore reflect the interest rates applicable to these money market transactions. The direction of the cash flows in the second leg of the swap is the oppo- site of those in the first leg of the swap. Consequently, as with money market transactions, currency swaps create only a temporary mismatch in cash flows. They do not create a net exchange position. TYPES OF CURRENCY SWAP 1. A pure swap is a swap in which both the spot and forward transactions are done simultaneously with the same counterparty.
eBook - PDF- A. Clare, C. Wagstaff(Authors)
- 2011(Publication Date)
- Palgrave Macmillan(Publisher)
This can be arranged very easily via an investment bank acting as the swap counterparty. This is known as a for- eign currency swap. Of course, for the swap to work it requires another entity that is willing to receive payments in euros in return for making payments in sterling. Swaps are really this simple. The complicated bit comes from determining the basis for the swap. In our example this means determining what ster- ling cash flow is equivalent to a euro cash flow. Complications also arise in valuing the two parts of the swap over time. But the principle remains: pay away the cash flow that you do not want, in exchange for one that you do want. In this chapter we will focus on two types of swap that are now used quite exten- sively for risk management purposes, and which have both become synony- mous with de-risking and Liability Driven Investment (LDI), which we discuss in Chapter 15: i. fixed for floating Interest Rate Swaps, and ii. inflation swaps. Swap contracts have become an important feature in the defined benefit (DB) pensions landscape over the past few years. This is because they can be used to help manage some of the risks that a DB pension fund faces. There are two risks in particular. The first is interest rate risk. When interest rates fall the present value of a scheme’s liabilities usually rise by more than the value of its assets. This is because the duration of a typical pension scheme’s liabilities is usually much longer than the duration of any bond assets that it might hold. An interest rate swap can help to create a situation whereby the net position of a pension fund’s assets and liabilities are largely unaffected by the fall or rise of interest rates in the wider economy. The second risk relates to inflation. A significant proportion of the DB pensions payable in the future are inflation protected, or index-linked, to some degree. This means that the pension in payment will tend to rise with future inflation.
eBook - ePubDerivatives
Theory and Practice
- Keith Cuthbertson, Dirk Nitzsche, Niall O'Sullivan(Authors)
- 2019(Publication Date)
- Wiley(Publisher)
CHAPTER 35 Other Interest Rate Swaps Aims To price and value ‘non-standard’ Interest Rate Swaps such as variable rate swaps, off-market swaps, zero-coupon swaps, swaps with variable notional principals and basis swaps. The swap rate on more complex Interest Rate Swaps can be determined by making the present value of the fixed leg of the swap equal to the (expected) present value of the floating leg (at inception of the swap) – as for plain vanilla swaps. However, the methods used in calculating these present values differ for exotic swaps. To show how swap dealers hedge their Interest Rate Swaps book using other fixed income assets such as FRAs, bonds, interest rate futures, and interest rate options. To demonstrate how to hedge the credit risk of a swap position using collateral, netting and credit enhancements. 35.1 SWAP DEALS There are a wide variety of swap contracts which can be designed to suit particular customers' requirements. In a spread-to-LIBOR swap, the floating rate is not at LIBOR-flat but at LIBOR plus a spread. Since most floating-rate bank loans contain a spread over LIBOR, this swap can be constructed to exactly match the floating payments in a LIBOR bank loan. In an off-market swap, the fixed swap rate is set at whatever rate is chosen by the ‘customer’ (e.g. a corporate) – for example, this off-market swap rate might be chosen to exactly match the fixed rate on an existing bank loan. In a zero-coupon swap the fixed payment is not periodic but consists of one ‘lump sum’ payment at the maturity of the swap. Some corporates may have fixed interest rate loans where the fixed payments change over time in a predetermined way – for example, the fixed rate might be 3% p.a. for the first 10 years followed by a fixed rate of 4% p.a. for a further 5 years. To match the payments in such a loan the corporate might use a swap to ‘receive fixed’ but the swap has a pre-agreed changing path for the (fixed) swap rate which matches that on the bank loan
eBook - PDFDerivative Instruments
A Guide to Theory and Practice
- Brian Eales, Moorad Choudhry(Authors)
- 2003(Publication Date)
- Butterworth-Heinemann(Publisher)
Swap applications can be viewed as being one of two main types, asset-linked swaps and liability-linked swaps. Asset-linked swaps are created when the swap is linked to an asset such as a bond in order to change the characteristics of the income stream for investors. Liability-linked swaps are traded when borrowers of funds wish to change the pattern of their cash flows. Of course, just as with repo transactions, the designation of a swap in such terms depends on from whose point of view one is looking at the swap. An asset-linked swap hedge is a liability-linked hedge for the counterparty, except in the case of swap market making banks who make two-way quotes in the instruments. A straightforward application of an interest rate swap is when a borrower wishes to convert a floating-rate liability into a fixed-rate one, usually in order to remove the exposure to upward moves in interest rates. For instance a company may wish to fix its financing costs. Let us assume a company currently borrowing money at a floating rate, say six-month LIBOR 100 basis points fears that interest rates may rise in the remaining three years of its loan. It enters into a three-year semi-annual interest rate swap with a bank, as the fixed-rate payer, paying say 6.75% against receiving six-month LIBOR. This fixes the company's borrowing costs for three years at 7.75% (7.99% effective annual rate). This is shown in Figure 6.5. Example 6.3: Liability-linked swap, fixed-to floating-to fixed-rate exposure A corporate borrows for five years at a rate of 6% and shortly after enters into a swap paying floating rate, so that its net borrowing cost is LIBOR 40 bps. After one year swap rates have fallen such that the company is quoted four-year swap rates as 4.90±84%. The company decides to switch back into fixed-rate liability in order to take advantage of the lower interest rate environment. It enters into a second swap paying fixed at 4.90% and receiving LIBOR.
eBook - PDF- R. Cooper(Author)
- 2003(Publication Date)
- Palgrave Macmillan(Publisher)
LONG-TERM CROSS-CURRENCY SWAPS A long-term cross-currency swap can be defined as an agreement between two parties to exchange interest obligations or receipts in different curren- cies. With a typical cross-currency swap there is an initial exchange of principal and a re-exchange at maturity. The underlying interest payments can be fixed or floating. The need for cross-currency swaps arises from a number of different situations: ᔢ to convert a loan raised in a foreign currency into the company’s domestic currency ᔢ to hedge a foreign-denominated asset into a domestic currency ᔢ to convert foreign currency cash balances to a domestic currency for a period of time. Table 10.10 Schedule for determining the appropriate interest rate derivative to use based upon specific views on interest rates Interest rates Interest rates Interest rates will rise will remain stable will fall Strongly agree Take out swap Use collar or other Leave or combination of purchase out of derivatives money cap No view Buy swaption Use collar or other Buy swaption combination of or interest derivatives rate cap Strongly disagree Buy cap Take out swap Take out swap or buy cap or collar 225 INTEREST RATE DERIVATIVES Example of use of long-term cross-currency swap A Hong Kong-based company, with no US$ income, has access to the US private placement market. It raises US$50 million by means of a five-year private placement. Summary details are shown in Table 10.11. However, the company’s requirement is for HK$ at floating rate. If it sells the US$50 million it has raised for HK$ spot, then it is exposed to movements in the US$/HK$ exchange rate. This exposure occurs for two reasons. First, it has to finance the US$ interest payments out of HK$ income, and second, it has to repay the US$ loan on maturity from HK$ resources. To hedge these exposures the company enters into a five-year cross-currency swap.
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